AMERICAN BOND VIGILANTES – ASLEEP AT THE WHEEL

With the debt ceiling discussions in full fearmongering mode and the Euro debt crisis causing increased global turmoil, there’s been an increase in the use of the term “bond vigilantes”.  And despite all these increasing debt fears we just can’t see any American bond vigilantes on the horizon.  In fact, every time this crisis in Europe seems to flare up and the risk off trade occurs, we see a dive in U.S. government yields.

Where in the world are these bond vigilantes?  Well, they don’t really exist.  As David Rosenberg recently showed, US government bond yields have an interestingly high correlation with Fed policy (88%).  Of course, for those of us who understand how the system works, the reasoning behind this is quite clear.  The US monetary system is quite different from that of Europe’s so there is no financing mechanism at the Federal level.  So, while muni bonds might be comparable to Greek bonds, the analogy doesn’t hold true for Greece and the US Federal government.  The result is that bond yields in the USA largely reflect Fed policy and the reserve drain that the US government bond market truly represents.   Thus, as previously mentioned, there are no bond vigilantes in the USA as there are in Europe:

There are no bond vigilantes to come after the USA for fear of solvency. There is simply no such thing. The only form of insolvency the USA faces is in the form of hyperinflation and that is a very different phenomenon than the one we currently are at risk of.

Comparing an EMU nation to the US Federal government is a terrible flaw that we see day after day. It contributes nothing but fear to the conversation and exposes the fear mongerer as having a severe misunderstanding of the workings of monetary systems. Well over a year ago I warned of this fear mongering. Luckily, we have not succumbed to it (and our economy is recovering – though slowly), but that hasn’t stopped millions from trying to scare the rest of us into believing that our Greek moment is right around the corner….”

Bond traders in the USA get this.  If there is one axiom that holds true in U.S. government bond markets it is “Don’t fight the Fed”.   I doubt that all US government bond traders understand the idea that there is no solvency issue at the US Federal level, but they do understand that the Fed essentially controls the entire curve via short-term policy moves. They know it because they’ve watched men like Niall Ferguson, (who has been ranting about surging US government bond yields for almost an entire decade) make this mistake based on faulty analysis.  And while Niall Ferguson can push political fear mongering that is wrong for nearly an entire decade and not get fired by his employer, the same cannot be said of bond traders who don’t have the luxury of being wrong for 10 years straight.

So, we’re likely to hear increasing banter from certain circles who are calling for higher yields in US government bonds as the vigilantes supposedly “wake up” and “force the issue”.  But as I’ve long maintained, we are a long way from higher rates in the USA or a bond market bubble collapse.  Yields will continue to reflect the low growth and low inflation environment that the Federal Reserve sees.

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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